Question

Discuss how debt financing is different from equity financing. How does debt financing effect cash flow, taxation expenses, and the balance sheet of a firm?

Answer 1

Debt and equity are the 2 ways of raising money for a firm. Both have been compared in below table

Comparison Basis	Equity	Debt
Definition	Company raises fund/capital by issuing shares	Company raises fund/capital by borrowing money from some other company
It reflects?	Ownership in the company	Obligation of the companny to pay back the loan
What type of funds?	Own Funds	Loan
Duration	Long term	Short term (relatively)
Risk Associated	High	Low
Returns generated	Dividend	Interest on loan
Example	Shares/Stocks	Bonds, Debentures
Collateral need	No	May be required to secure the loan

Debt financing affecting various components

1. Cash Flows: This statement shows how the company has generated its cash and where are they using the money. It shows all the money coming in or going out due to 3 types of activities: operating, investing and financing. Debt financing introduces a positive entry under financing part of the cash flow statement (meaning the cash/debt has come into the firm). Interest payments also reduces the net cash available for the company as it is an outgoing cash.

2. Taxes: We need to pay interests on the loan/debt we have taken. And that interest is tax deductible. This makes the "actual" borrowing cost to be lower than the "stated" cost/rate. There is a caveat that the loan/funds must be used only for business purposes and not for personal use.

3. Balance Sheet: In this we capture the debt financing under the liabilities section. This can further be divided into short-term and long-term loans/debts. Firstly, debt financing reduces the overall equity of the firm. Secondly, this amount will tell the investors/lender about the financial status of the company. It can be used to calculate the the debt to worth ratio which can give image about the company's business health. If debt is too high, then more lenders might not give you more money as it can be risk (paying back interest). Then Debt-Equity ratio, can be used to calculate the cost of capital to company (WACC).